Over the past few days, concerns on emerging markets volatility have again resurfaced, with various central banks either raising rates or not cutting them, as widely expected. In an increasingly interconnected world, vulnerable to capital surges, both inflows and outflows, there has to be a degree of coordination between emerging markets policymakers to ensure that any one specific country is not subject to volatility driven by arbitrage flows.
In addition, new data based on RBI surveys on inflation expectations, business confidence, capacity utilisation and inventory levels also suggest that business is reviving, however moderately, with the potential to translate into higher core inflation.
One of the reasons why there was a divergence in market expectations and RBI actions was the assumption behind the one-year-ahead inflation trajectory. RBI projections, it turned out, were conditional on a 25 basis point (bps) repo rate increase, whereas ours was non-conditional.
But one trade-off the Governor was quite emphatic on: The so-called trade-off between inflation and growth is a false trade-off in the long run. The reasons for this statement were laid out clearly in the preceding paragraph of his statement. There is also no question whatsoever that high inflationwhatever the economic contextsignals excess demand and is adverse to growth through a potential wage price spiral set off by inflation expectations.
This brings us to the recommendations of the Urjit Patel committee report, whose philosophy is consistent with the aforesaid statement. The report itself is an excellent read, an analytically oriented scaffolding to move Indias monetary policy decisioning to a modern, deliberative framework, in line with best practices in much of the developed world, and increasingly in emerging markets.
Much has already been written on the salient points of the committee report. In particular, the lure of inflation-targeting in terms of providing a quantifiable objective and in imparting clarity and a measure of certainty to the choice of instrument is unquestionable. What has been the global experience of inflation-targeting The accompanying table, sourced from a Sweden Central Bank research document (cited below), shows the effects of inflation-targeting across countries, in the two periods (pre-crisis) 2000-06 and (post-crisis) 2007-12, grouped into developed and emerging markets.
For developed markets (DMs), the evidence is a bit puzzling. In both the pre- and post-crisis periods, inflation had been higher for inflation-targeting DMs (and consequently inflation expectations), while at the same time, the former countries have managed higher growth. It is also puzzling how this came about since Japan (a deflation prone economy) is one of the inflation-targeting DMs. This raises questions about the symmetry of outcomes, since Japans inflation-targeting attempts to push inflation up towards a positive target.
The difference in outcomes between DMs and EMs is also marked. Although inflation-targeting EM central banks have been able to keep inflation as well as keeping inflation-expectations and growth volatility in check compared to non-targeting countries, there is a growth cost to inflation-targeting. Mean growth for inflation-targeting EMs was 4.51% versus 7.13% in the pre-crisis period and 3.85% versus 5.53% in the post.
Moreover, inflation volatility for inflation-targeting countries both emerging and developed markets post the global financial crisis rose to be higher than non- inflation-targeting countries, where it actually dropped for non-inflation-targeting EMs.
There is also a change in the growth versus inflation differential between inflation-targeting and non-inflation-targeting countries during the high growth (great moderation) phase of 2000-06 compared to the volatile period. Non-inflation-targeting EMs were able to reduce inflation expectations more than inflation-targeting EMs (although, to be fair, inflation-targeting EMs managed to reduce inflation expectations despite an increase in actual inflation).
While acknowledging that the above data is only one aspect of a complex relationship, the hypothesis of an absence of a long-term trade-off between inflation and growth needs, while intriguing and even intuitive, particularly accompanied by a coherent cause and effect rationale, clearly needs more analytic and empirical study. Even more, the data raises questions on the causality between inflation-targeting in fostering a stable growth and inflation environment. Is stable growth the result of inflation-targeting approach or are the superior inflation-targeting outcomes the result of periods of macroeconomic stability, which might have been caused by factors exogenous to a inflation-targeting monetary policy approach
An associated issue, of course, is the target level for inflation for an inflation-targeting central bank. Is the success of an inflation-targeting approach dependent on the choice of a target in relation to historical trends, or does the announcement of a target shape households inflation expectations, either adaptively or otherwise In this context, what is the feasibility of achieving the stated target of 4 +/- 2% CPI inflation recommended in the committee report That is the subject of a separate article..
The author is senior vice-president & chief economist, Axis Bank. Views are personal